Once a year, I go through my closet to identify clothes that I haven’t worn in a long while. My intent is to determine which things to keep, which to part with, and which items are so worn that they are destined for my “rag bag.”
I do a pretty good job thinning the wardrobe, with one exception: a Pittsburgh Pirates authentic Major League Baseball jersey. I haven’t worn the jersey in many years or followed the Pirates in forever, but each time I go through my closet, I cannot bring myself to part with it.
I know that a professional organizer, or just an unbiased onlooker, would tell me to get rid of the jersey to better utilize the space in the closet. So why do I keep it? Because I have an attachment that is influenced by two irrational biases: the endowment effect and loss aversion.
The endowment effect contends that people assign a higher value to an item simply because they own it. Occasionally, I have tried to sell the jersey, but the going rate for similar jerseys is lower than what I paid years ago. I feel the value of my jersey should be higher than the current market value especially when I recall how hard I worked at a summer job in high school to save enough money to make what was for me, at the time, a relatively expensive purchase.
The second hurdle keeping me from parting with the jersey is loss aversion. Loss aversion is the bias against incurring losses, even if taking the loss now provides an opportunity to acquire a gain. If I sell my jersey for less than I paid, even though I would make money, I would think of it as a loss relative to what I paid.
People wrestle with the same type of financial behaviors when it comes to investments. Have you ever bought a stock only to watch its value drop? Then as the price stays depressed you continue to hold it because you do not want to realize the loss and move on, even if you could reinvest the proceeds from the sale elsewhere. If this sounds familiar, please know that you are not alone. The endowment effect and loss aversion are common biases that are deeply embedded and contribute to irrational decision making.
At Woodward Financial Advisors, one role we serve in our clients’ financial lives is akin to a ‘behavioral surge protector.’ In this role, we work with clients to identify potential biases. This allows us to offer objective advice and take action on their behalf in these situations.
For example, during the latter part of 2015, we harvested losses within our client portfolios by selling certain positions that were worth less than what the clients originally paid. We then reinvested those proceeds in different funds that kept the clients’ portfolios appropriately diversified. These actions conferred a tax savings benefit to our clients while keeping their assets invested.
Could our clients have harvested their own losses? Perhaps. But then again, biases could have clouded their decision making much the same way it has kept me from letting go of an old baseball jersey.
Financial matters, including investment decisions, can be influenced by emotions and biases. Even when you are aware of these influences, it can be challenging to overcome them. A value we provide to our clients is personalized advice and action to mitigate these biases. If you or someone you know could benefit from working with a team of advisors who offer client-centered objective advice, please contact us.